Managing financial risk: Overseas trade Flashcards
Transaction risk
Transaction risk is the risk that an exchange rate will change between
the transaction date and the subsequent settlement date i.e. it is the
gain or loss arising on conversion.
It arises primarily on imports and exports.
Economic risk
Economic risk is the variation in the value of the business (i.e. the
present value of future cash flows) due to unexpected changes in
exchange rates. It is the long-term version of transaction risk.
A favoured, but long term solution, is to diversify all aspects of the business
internationally.
Translation risk
Where the reported performance of an overseas subsidiary in homebased currency terms is distorted in consolidated financial statements
because of a change in exchange rates.
Note: This is an accounting risk rather than a cash based one.
Quoted exchange rates : How do banks dealing in foreign currency quote foreign exchange prices?
Banks dealing in foreign currency quote two prices (a ‘spread’) for an exchange rate:
- a lower ‘offer’ price
- a higher ‘bid’ price.
What should a company with signufucant currency risks do?
When currency risk is significant for a company, it should do something
to either eliminate it or reduce it.
Doing nothing may mean that the wins and losses even out in the long
run, however for a significant transaction, the risk is large enough to be
a problem.
Possible solutions to manage transaction risk
- Invoice in home currency
- Leading and lagging
- Matching
- Foreign currency bank accounts
Possible solutions to manage transaction risk: Invoice in home currency
Insist all customers pay in your own home currency and pay for all imports in
home currency.
This method:
– transfers risk to the other party
– may not be commercially acceptable
Possible solutions to manage transaction risk: Leading and lagging
If an exporter expects that the currency it is due to receive will depreciate over
the next few months it may try to obtain payment immediately (i.e. leading).
This may be achieved by offering a discount for immediate payment.
If an importer expects that the currency it is due to pay will depreciate, it may
attempt to delay payment (lagging).
This may be achieved by agreement or by exceeding credit terms.
NB: Strictly this is NOT hedging – it is speculation – betting on the exchange
rate changing in your favour!
Possible solutions to manage transaction risk: Matching
When a company has receipts and payments in the same foreign currency due
at the same time, it can simply match them against each other. It is then only
necessary to deal on the forex markets for the unmatched portion of the total
transactions.
Possible solutions to manage transaction risk: Foreign currency bank accounts
- Where a firm has regular receipts and payments in the same currency, it may
choose to operate a foreign currency bank account - This operates as a permanent matching process
- The exposure to exchange risk is limited to the net balance on the account.
Hedging with forwards: The method
As described in the previous chapter, if we know that we are going pay
or receive currency in the future, we will agree to translate this currency
at a rate agreed now (a forward rate).
A forward contract is an
obligation to accept or deliver a certain amount of a foreign currency on
a certain date in the future.
It is an over the counter product therefore can be arranged for any amount of any
currency on any date.
Quoted forward rates
Forward rates are quoted as a premium or a discount on the spot rate.
Quoted forward rates: What happens to the currency if the forward rate is at a discount
Currency is depreciated
Because more $ per £
Quoted forward rates: What happens to the currency if the forward rate is at a premium
Currency is appreciated
Because less $ per £
A money market hedge
Instead of hedging currency exposure with a forward contract, a company could use
the money markets to lend or borrow, and achieve a similar result.
Buy the present value of foreign currency amount today at the spot rate –
– this is like the firm making an immediate and certain payment in sterling
– and may involve borrowing the funds to pay earlier than the settlement
date
The foreign currency purchased is placed on deposit and accrues interest until
the transaction date
The deposit is then used to make the foreign currency payment.
Hedging a receipt
If you are hedging a receipt, borrow the present value of the foreign currency
amount today
– sell it at the spot rate
– this results in an immediate and certain receipt in sterling
– this can be invested until the date it was due
The foreign loan accrues interest until the transaction date
The loan is then repaid with the foreign currency receipt.
Hedging with futures
As described in the previous chapter, futures are the standardised version of
forwards.
They are like forwards in that:
1. The company’s position is fixed by the rate of exchange in the futures contract
2. It is a binding contract.
However:
1. Futures are for standardised amounts
2. Futures can be traded on currency exchanges.
Because each contract is for a standard amount and with a fixed maturity date, they
may not cover the exact foreign currency exposure.
Hedging with futures: Deciding whether to buy or sell (always sterling for exam): If Buying currency in the future
**If a company is going to be buying currency in the future, then it will be
SELLING sterling. It therefore needs to SELL sterling contracts.””
Hedging with futures: Deciding whether to buy or sell (always sterling for exam): If selling currency in the future
If a company is going to be selling currency in the future, then it will be BUYING sterling. It therefore needs to BUY sterling contracts.
Hedging with futures: Number of contracts
As usual, this will be the transaction amount divided by the contract size. However,
when using sterling contracts, the contract size will be in £ but the transaction
amount will be in currency. Therefore, you will need to convert the transaction
amount into £ first (using the futures price).
Hedging with futures: How to translate?
If using sterling contracts, the futures prices will be given as currency per £ (e.g. $/£),
therefore the profit or loss on the future will end up in the foreign currency and will
need to be translated at the SPOT RATE on the TRANSACTION DATE.
Premium on an optionH: ow to translate?
Because a premium is paid up front, it must be translated at the current spot rate.
Currency options
Options give the right but not the obligation to buy or sell currency at some point in the future at a predetermined rate.
A company can therefore:
1. Exercise the option
2. Let it lapse if:
– the spot rate is more favourable
– there is no longer a need to exchange currency.
The option therefore eliminates downside risk but allows participation in the upside.
The additional flexibility comes at a price – a premium must be paid to purchase an
option whether or not it is ever used.
OTC currency options: Buy a put or call optoi when the company is going to be buying currency in the future
If the company is going to be BUYING currency in the future, then it will need to buy a CALL option.
OTC currency options: Buy a put or call optoi when the company is going to be selling currency in the future
If the company is going to be SELLING currency in the future, then it will need to buy a PUT option.
Puts or calls: Traded currency options (always sterling in exam): If company buying currency in the future
If a company is going to be buying currency in the future, then it will be SELLING sterling. It therefore, needs to buy
PUTS
Traded currency options (always sterling in exam): If company selling currency in the future
If a company is going to be selling currency in the future, then it will be BUYING
sterling. It therefore needs to buy CALLS.
Cryptocurrency
Cryptocurrency is a digital currency that uses cryptography to make sure payments
are sent and received safely
Cryptocurrency: FOREX benefits
They can be useful for transactions involving foreign currency, as both parties can agree to settle the transaction with a cryptocurrency, such as Bitcoin (BTC) rather
than using foreign currency hedging techniques.
Cryptocurrency: Problems
- Exchangeability – can only exchange for a narrow range of major currencies.
- Price volatility – cryptocurrency exchange rates are extremely volatile.
However, there are opportunities to hedge this risk.
Cryptocurrency: Forward contracts
Forward contracts are tailored to the individual and allow a business to hedge the value of a cryptocurrency in advance.
Cryptocurrency: Futures contracts
Bitcoin futures are standardised contracts (standard amounts and dates) that can be
traded on an exchange, to protect against future changes in the value of Bitcoin.
Cryptocurrency: Futures contracts: Whether to buy or sell: For a payment in Bitcoin
For a payment in Bitcoin, the company is concerned the price of Bitcoin will rise and
make the purchase of the required Bitcoin more expensive = BUY futures today.
Cryptocurrency: Futures contracts: Whether to buy or sell: For a receipt in Bitcoin
For a receipt in Bitcoin, the company is concerned the Bitcoin price will fall and
therefore receive less from exchanging Bitcoin = SELL futures today
Cryptocurrency: Number of contracts
Bitcoin futures are in a standardised size, such as 5 Bitcoin. The number of
contracts will be the transaction divided by the standard size.
Why exchange rates fluctuate?
- Purchasing power parity (PPP)
- Spot rates, forward rates and interest rate parity theory (IRPT)
Why exchange rates fluctuate: Purchasing power parity (PPP)
PPP claims that the rate of exchange between two currencies depends
on the relative inflation rates within the respective countries.
PPP is based on ‘The Law of One Price’
Why exchange rates fluctuate: PPP:’The Law of One Price’
In equilibrium, identical goods must cost the same regardless of the currency in
which they are sold.
The country with the higher inflation will be subject to a depreciation of its
currency.
Why exchange rates fluctuate: Law of one price: Expected future spot rate formula
CurrentSpotRate * ForeignInfl%/UKInfl%
Why exchange rates fluctuate: Spot rates, forward rates and interest rate parity theory (IRPT)
Interest Rate Parity theory claims that the difference between the spot and the future exchange rates is equal to the differential between interest rates available in the two currencies.
This is used by banks to calculate the forward rate quoted on a currency.
Why exchange rates fluctuate: (IRPT): Formula for forward rate quoted on a currency
CurrentSpotRate x ForeignInt**%/UKInt%
Does IRPT hold true in practice?
Yes. IRP holds true in practice. There are no bargain interest rates to be had on
loans/deposits in one currency rather than another.
However, where a government imposes controls on currency trading, or
otherwise intervenes in the currency markets, its effectiveness is limited.
Risks of overseas trading
- physical risk
- trade risk
- liquidity risk
- credit risk.
